Business

Retirement Planner: Careful analysis needed when picking stock

By Stephen J. Butler sbutler@pensiondynamics.com

Posted:
12/08/2013 12:01:00 AM PST

Someone recently suggested that railroad stocks in this country were about to take a hit because the new Panama Canal would take larger ships and that the "land bridge" served by railroads bringing Chinese-made goods from the West Coast to the rest of the country would be hit hard.

But acting on information like that is what gets amateur investors into trouble. I once had some money from my paper route that I invested in Studebaker stock when the company stopped making automobiles. I had read someplace that they would henceforth be profitable after expunging from their income statement the source of a string of annual losses. I turned out to be wrong. The managers that couldn't run the car company couldn't do any better with the other businesses they operated, and I lost money before bailing out.

Stock picking (and then knowing when to sell) is much more complicated than acting on "tips." My friend Mike O'Neill, founder of Sage Investment Management in Lafayette, has been in business for 40 years and once told me that he had never made money acting on a stock tip. It was beneath his dignity, anyway, because careful analysis is what goes into buying and selling stocks successfully and consistently over long periods of time.

If you're like my wife and get all excited about, for instance, the companies that make 3-D printers, you first should ask yourself some penetrating, analytical questions about the company. While the stock screens and questions that professional analysts use are voluminous, we'll look at just a few to show you what you're up against as an amateur competing with professionals investing in, for example, small companies. The following offers some of the fundamental analysis offered by the AAII (American Association of Individual Investors).

Advertisement

The book value of the company is the value of its assets based on what accountants show them to be. The total value of all the outstanding stock should be less than 80 percent of this value. In simple terms, if you could buy the whole company based on its stock market price, you should be able to then sell all the assets and make at least a 25 percent profit.

What this is saying is that the stock is worth buying if the price is less, per share, than the book value of the company per share. Moreover, the firm's last quarter and the last 12 months' earnings must be positive. Thanks to the disconnect between stock prices and the intrinsic value of the companies they supposedly represent, the system allows careful investors to invest at bargain prices -- and then wait for their judgment to be vindicated.

The Internet is full of stock screening tools that identify companies that meet the criteria outlined above. One uses a price-to-sales ratio rather than book value. There's usually a combination of metrics that signal when the planets are lined up enough to signal a buy.

Meanwhile, there's the issue of when to sell -- a decision that's just as important as the purchase. In the AAII model, the point at which the stock price is three times the book value per share is the time to dump the stock, take a profit and move on. Also signaling a sell is the point at which the stock rises by 300 percent of its purchase price.

What can also trigger a sale is the clue that things may not turn out as expected. In other words, maybe the stock was beaten down lower than 80 percent of the company's book value for a reason that others had figured out. If the last 12 months of earnings are negative, the stock is put on probation. If the next quarter produces a loss, it's sold. Cutting your losses and letting your profits ride is a watchword of the investment management industry.

All I'm saying is that we're often tempted to buy some stock about which we've heard a tidbit of news or because it involved a product we liked. Peter Lynch, the old Fidelity Magellan manager, wrote a whole book expounding on the wisdom of that approach. As I recall, he invested in the company that made L'eggs (the women's nylons) based on the "I-use-and-like-the-product" hypothesis.

Magellan at one time, however, owned shares of more than 800 companies and it created their own microclimate. Just the news that they were buying a company made the latter's shares go up in value. For the rest of us, being consistently successful at stock picking (and selling) involves some work.